Fin573 Fall 2007 Manager: Suhardi Abadi Sector: Consumer Staples Industry: Food and Nonalcoholic Beverage Company:

PepsiCo (PEP) Recommendation: BUY 70 SHARES Company Overview PepsiCo is part of the global snack and beverage industry. Originally incorporated in 1919, the company manufactures, markets and sells a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages, and foods. With a market capitalization of $120 billion, PepsiCo is one of the largest manufacturers of branded food and beverages in the world with businesses in the United States and in more than 200 countries. Industry Overview The United States food and nonalcoholic beverage industry consists of companies that process or manufacture packaged foods and beverages for human consumption. The food companies produce goods such as dairy products, baked goods, microwaveable/instant dinners, condiments, and snack foods. They sell their finished goods to food retailers, which in turn sell the products to consumers. The beverage companies manufacture carbonated soft drinks, bottled water, juices and juice drinks, sport drinks, and ready-to-drink teas. The beverage industry in general is grouped into bottling companies and franchise companies (or brand owners). Bottlers are generally responsible for manufacturing, selling, and distributing products under brand names licensed from brand owners in an exclusive territory. However, bottling systems are not necessarily exclusive. Brand owners, such as PepsiCo, are mainly in the business of making soft-drink concentrates; flavored syrups that are mixed with carbonated water to produce various beverages. In addition, they support their brands by developing national marketing programs and providing local marketing support to their bottlers. According to Beverage Marketing Group, an industry marketing firm, about 51% of beverages consumed in the United States are carbonated soft drinks (CSDs), followed by bottled water (28%) and fruit beverages (14%). The industry outlook for 2007 is projected to have earnings increase by about 6% on average, bolstered by sales of new products and growth in foreign markets. Pressure on margin from high input costs should be partly offset by price increase and improvements in productivity due to restructuring programs. Volumes are expected to increase due to introductions of new products that focus on a healthier diet.

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External Factors Industry Structure The US food industry is much more fragmented compared with the beverage industry. The typical food company is small and produces a limited number of products for regional or specialized market. Major firms tend to ignore regionalized markets and focus on multimilliondollar products that can be sold nationally (or internationally). In contrast, the nonalcoholic beverage industry is concentrated in the hands of a few giants. For example, data from Beverage Digest shows that Coca-Cola Co., PepsiCo, and Cadbury Schweppes (which owns Dr. Pepper & 7 UP brands) account for 89% of the US soft-drink retail sales in 2006.
Exhibit 1 Top 20 Publicly Held U.S. Food & Beverage Companies (Ranked by 2006 sales, in millions of dollars)

Source: Company reports. (Snapshot taken from S&P Industry Surveys Food & Nonalcoholic Beverages. 7 June 2007:8)

Distribution Channels Companies distribute food and beverage products through various channels. Some companies use a direct-delivery system where the products are delivered directly to retailers. Others use a warehouse system where the retailers transport the products from the warehouse to their stores. PepsiCos go-to-market distribution system is considered to be one of its primary competitive advantages1. Primary distribution channels for beverages are supermarkets, mass merchandisers,
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Annual Report 2006. PepsiCo.

vending machines, convenience stores, fountain accounts and other outlets. Supermarkets are currently the largest channel of distribution for carbonated soft drinks (CSDs). Their shares however have been shrinking while mass merchandisers, convenience stores, and gas station stores have been gaining2. Important Industry Trends Consumers have always ranked taste, convenience, and value as the factors they consider when purchasing food and beverages. With the increasing awareness of health issues related to poor dietary habits, consumers in recent years have increasingly put more spotlights on healthy product offerings. There have been declining demands for products that are high in sodium, fat, or sugar. For example: carbonated soft drinks (CSDs) have been losing market share to bottled water, sports drinks, and other beverages such as iced teas. Sales figures from 2006 shows that the volume of CSDs sold fell 1.1% compared with gains of 49.1% for energy drinks and 26.2% for ready-to-drink teas3. One of the fastest growing beverage segments in recent years is bottled water; driven primarily by consumer concerns about the safety of municipal water supplies, interest in healthy living and the populations increasing affluence. Companies that introduced new products tailored for healthier diet are rewarded with rising sales and profits, especially those that introduce healthy products without sacrificing taste. PepsiCos SoBe-branded juice-drinks are a good example. Acquired in 2001, it gave Pepsi a core anchor in the fast growing non-CSD market with products that combine both the health benefit of fruitbased ingredients and great tastes3. The food and beverage companies have raised the profile of their healthier products through advertising and new packaging, and have supported restricting childrens access to junk food in schools. Market research has shown that with busier schedules, US consumers are eating more meals outside of the home. Food companies are coming out with packaged foods for people on-the-go. No wonder snacks are a big business in the US, with sales worth $67 billion according to consulting firm Datamonitor. PepsiCo is an industry leader in this category; other players include Kraft Foods and Hershey. New products are also being introduced to respond to demographic shifts toward smaller household sizes. Products are packaged for smaller size consumption. Companies are trying to take the convenience of take-out or restaurant dining into the dining table. The introduction of microwave-able or instant dinners that is easy to do and taste great appeal to the lifestyle of working professionals. Another trend in the industry is the rising importance of overseas market for growth. With strong competition and limited population growth in the US, many are turning to the developing markets of Latin America, Eastern Europe and Asia. Both regions are experiencing growth in population and economy, with increasing middle-class consumers that are more predisposed to well-known American brand names. Although in some places foods and beverages are currently purchased in small stores, there is a trend toward opening more supermarkets and hypermarkets which will increase the likelihood that consumers will buy packaged foods and beverages. Large food and beverage companies initially entered foreign markets through joint ventures with local companies. The strategy is to learn from its partner about the local customs, tastes, and

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Annual Report 2006. PepsiCo.

regulatory process. Afterwards, many companies acquire their partners and build on their business through more joint ventures or outright acquisitions. Regulatory Almost all food and beverage products in the US are subject to regulations administered by the US Food and Drug Administration (FDA), or the USDA if the product contains meat and poultry. In addition, individual states can be involved also in the regulatory process. Companies that have foreign operations may need to satisfy other countries standards in identifying / labeling and grading products. All of these can have substantial effects on costs. Important Ratios and Statistics Changes in disposable income and the consumer price index (CPI) can influence consumers spending behavior4. The forecast is for disposable personal income to rise by 5.4% in 2007 and 5.3% in 2008; compared with 5.4% in 2006. CPI is projected to rise 2.1% in 2007 and 2.0% in 2008; compared with 3.2% in 2006. Some other important figures include the producer price index (PPI), interest rates, and currency exchange rates. Producer price index is an indicator of price inflation for the raw materials used by the manufacturing companies. Increases in the index could mean cost pressure that hurt the companies margins. Food and beverage companies such as PepsiCo cannot alter their product prices quickly enough or even pass all the costs to consumers. The last one is due to price elasticity, competitive factor, and contractual commitment with retailers. Interest rate changes are important for companies as they consider their fiscal policies, affecting thing such as acquisition activity, capital expenditures, dividends, and stock repurchases. Currency exchange rate is particularly important for companies with significant operations in foreign markets, as an increase in the value of the US dollar compared with foreign currencies could decrease reported profits.

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Annual Report 2006. PepsiCo.

Corporate Strategy PepsiCo is a successful company with a strong portfolio of brands. Overall, it has 16 brands which individually generate $1 billion or more in annual sales. The largest is of course PepsiCola, followed by Gatorade and Mountain Dew.
Exhibit 2 PepsiCos Largest Brands

Sources: Annual Report 2006, PepsiCo.

While carbonated soft drinks (CSD) remain the most popular beverage, PepsiCo recognizes that non-carbonated drinks are a faster growing category. To that end the company plans to continue to innovate in that area, following its success with Lipton teas, Aquafina water, Tropicana juices, SoBe, Gatorade, and Propel. In 2006, it added Naked Juice, and Izze sparkling juices to the portfolio. Another trend the company is focusing on is the expansion of health and wellness awareness. PepsiCo has eliminated trans-fats from many of its snack foods, and is increasingly introducing "good for you" foods under the Quaker Oats brand. PepsiCo has a program called Smart Spot that showcase products that met the required nutrition recommendation from US FDA and National Academy of Sciences. Overseas growth has been a focus for PepsiCo; regions such as Russia, Middle East, and China have experienced double-digit growth in snacks and beverages. All the international sales are handled by PepsiCo International division.

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Exhibit 3 PepsiCos International Growth

Sources: Annual Report 2006, PepsiCo.

Organizational Structure PepsiCo is organized into four business segments: Frito-Lay North America (FLNA), PepsiCo Beverages North America (PBNA), PepsiCo International (PI) and Quaker Foods North America (QFNA). The company's North American divisions operate in the U.S. and Canada. PepsiCo's international divisions operate in more than 200 countries, with its largest operations in Mexico and the United Kingdom. FLNA (31% of 2006 net revenue, 41% of operating profits before corporate overhead) produces the bestselling line of snack foods in the U.S., including Fritos brand corn chips, Lay's and Ruffles potato chips, Doritos and Tostitos tortilla chips, Cheetos cheese-flavored snacks, Rold Gold pretzels, Sunchips multigrain snacks, Grandma's cookies, Quaker Fruit and Oatmeal bars, Quaker Chewy granola bars, Lay's Stax potato crisps, Cracker Jack candy-coated popcorn and Quaker Quakes corn and rice snacks. FLNA branded products are sold to independent distributors and retailers. Products are transported from Frito-Lay's manufacturing plants to major distribution centers, principally by company-owned trucks. PBNA (27% of 2006 net revenue, 31% of operating profits before corporate overhead) manufactures or uses contract manufacturers, markets and sells beverage concentrates, fountain syrups and finished goods, under the brands Pepsi, Mountain Dew, Sierra Mist, Mug, SoBe, Gatorade, Slice, Tropicana Juice Drinks, Tropicana Pure Premium, Dole, Tropicana Season's Best, Tropicana Twister and Propel. PBNA also manufactures, markets and sells ready-to-drink tea and coffee products through joint ventures with Lipton and Starbucks. In addition, it markets the Aquafina water brand and licenses it to its bottlers. Pepsi-Cola bottlers are licensed by
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PepsiCo to manufacture, sell and distribute, within defined territories, beverages and syrups bearing the Pepsi-Cola beverage trademarks. PI (37% of net revenue in 2006, 30% of operating profit before corporate overhead) manufactures through consolidated businesses, as well as through noncontrolled affiliates, a number of leading salty and sweet snack brands including Sabritas, Gamesa and Allegro in Mexico, Walkers in the United Kingdom, and Smith's in Australia. PI also manufactures, markets and sells beverage concentrates, fountain syrups and finished goods under the brands Pepsi, 7UP, Mirinda, Mountain Dew, Gatorade and Tropicana outside North America. These brands are sold to franchise bottlers, independent distributors and retailers. However, in certain markets, PepsiCo International operates its own bottling plants and distribution facilities. In order to capture local or regional markets, PepsiCo has customized its products to match not only local culture but also local taste5. QFNA (5% of 2006 net revenue, 9% of operating profit before corporate overhead) manufactures, markets and sells Cap'n Crunch and Life ready-to-eat cereals, Quaker hot cereals, Rice-A-Roni and Near East flavored rice products, Pasta Roni pasta products, Aunt Jemima mixes and syrups and Quaker grits. Looking at the sales figures, it is apparent that North America still represents the bulk of PepsiCos revenue. However, international sales (as represented by Pepsi International) are growing strong and have become an important part of PepsiCos continuing success. The charts before have shown that international snacks have a lot of tail-wind, and international beverages are doing well too, as Pepsi continue to pursue local experts and does not rely on its own expertise to develop new products. An example of this market research is how PepsiCos R&D Center use computerized laboratories to develop a chemical fingerprint of beverages so they can be easily replicated, and how they employed specialized tasters, local people who can accurately differentiate sweet, sour, salty and bitter tastes, and can pick out subtleties in flavoring6.

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Cost Structure Listed below is the typical breakdown of industry costs in production, which add up to about 80% of the total costs: Labor is the largest element, representing about 38.5% of every consumer dollar spend on food. Agricultural commodity is the second largest expense, which account for about 19% of total costs. Packaging account for about 8% of every dollar spent by consumers. Transportation account for about 4% of the total costs. Other costs include energy (3.5%), advertising (4%), and business taxes (3.5%). Although agricultural commodities account for the second largest expense mentioned above, manufacturers are less sensitive to changes in raw material costs than the agribusiness companies. Margins are easier to maintain due to the added value that came from packaging and marketing. In addition, food manufacturers actively use hedging techniques, such as global sourcing, to help limit their exposures to fluctuating input prices. Nonetheless, food and beverage companies are still facing high prices on a number of key commodities, including wheat, corn, and soybeans. These are caused by climate issues, increasing demand (particularly corn due to increasing use of ethanol in fuel), and crop selection by growers. Cost of some packaging materials (such as glass and aluminum) has risen as well and fuel prices continue to be high. Companies have passed some these higher input costs to the consumers by raising prices. However, there are limits on how much cost can be passed on, as determined by the elasticity of the products. PepsiCo manage the risk of changing commodity, packaging and energy costs through a variety of strategies, including productivity initiatives, global purchasing programs and hedging strategies4. Ongoing productivity initiatives involve the identification and effective implementation of meaningful cost saving opportunities or efficiencies. Global purchasing programs include fixed-price purchase orders and pricing agreements. Hedging strategies include the use of derivatives, and typically used to guard against exchange rate risk. Due to the maturity of the food and beverage market in the US, many companies are restructuring by cutting costs, divesting unprofitable products, and doing select acquisitions for lines of business that complement their existing operations. The strategy is intended to help companies improve their operating margin and compete more effectively with new products. The maturing market also limits the food and beverage companies flexibility in setting price. This inflexibility is a concern to brand name producers due to the constant threat of private-label goods. One of the best ways to increase their pricing power is by increasing brand awareness, which they hope will translate into customer loyalty. The food and beverage companies are some of the nations leading advertisers. Beverage industry giants such as PepsiCo derive substantial profits from foreign operations; such companies have periodically been affected by fluctuating foreign currency exchange and variability in regional demand. Exchange rates between US dollar and foreign currencies

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continue to increase in importance as food and beverage companies are looking to overseas for growth. Competitive Environment The food and beverage industry where PepsiCo is competing is stable and mature, especially in the North America. The barriers to entry in the US food and beverage industry depend on the playing field: on the local level, the technological skills and financial resources required are not substantial. On a larger scale, however, the capital requirements to build manufacturing facilities, marketing and distributing the products, is quite high indeed. Small and regional companies have entered and found success in the market with unique products that satisfy the demand for healthy and organic products. In order to continue the growth and reach national distribution level, many of these companies have been or are in the talk of being acquired by larger companies. One example is SoBe, which was acquired by PepsiCo in 2001. Private-label manufacturers are another competitive force in the market, especially during depression, with consumers tendency to substitute higher-priced brand name goods with lowerpriced private-label products. Some of these products are manufactured and marketed for retailers that also carry PepsiCos products. This present a dilemma in pricing negotiations between manufacturers and retailers; however, PepsiCos continuous development of new products ensures that its products will remain competitive and sought after by consumers. PepsiCo estimates that it is the second largest manufacturer of branded food and beverages in the world. Competition is fierce, with large rivals such as Nestle, Kraft, Unilever, Coca-Cola, Groupe Danone, and Cadbury Schweppes all attempting to gain share of consumers dietary habit. Kraft is its closest competitor in the US convenience snacks market, with Hershey being the third in term of market share. Coca-Cola is PepsiCos largest competitor in the beverage world, going back to decades of Coke and Pepsi fight. Currently, PepsiCo has an advantage in its brand portfolio compared with Coca-Cola, as both companies are noticing the shift of consumer interest in non-carbonated drinks. One example of their competitiveness is the introduction of Life Water product lines from PepsiCos SoBe brand, which was positioned as a direct competition for Coca-Colas Vitamin Water.

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Business Cycle Due to the nature of the products they manufacture, food and beverage industries are less sensitive to the declines in business activity than are companies in other industries. Historically, these companies have been considered to be safe investments during economic downturns. Although the quantity of food and beverage products consumed tends to remain steady during both good times and bad, consumers have the tendency to select less expensive private-label goods during times of economic weakness. Changes in disposable income and the consumer price index (CPI) can influence consumers spending behavior. With the current economy going into a weakening condition, manufacturers are keeping watch to see how that would affect their sales and profits. Some companies have warned of possible erosion in margin, others have cited increasing opportunities from overseas to offset the downturn in US market. Strengths and Risks Analysis Strengths Deep-bench management team, with a tradition of promoting from within. The recent transition of CEO from the veteran Steve Reinemund to Indra Nooyi was remarkably seamless. The company also willing to acquire and integrate attractive close-to-home businesses that can plug a hole in its brand portfolio and provide additional growths. With 16 brands each contributing $1 billion of sales or more, PepsiCo has a sweet-spot in the food and beverage market. Strong logistical / distribution infrastructure. After years of building this infrastructure, PepsiCo has an edge in making sure its products are available where needed cost effectively and efficiently. Growths from foreign (outside of North America) markets contributed increasingly to PepsiCos sales and profits. Continuing investment in research and development, with spending of $344 million in 2006. PepsiCo has spotted the shifting trends in consumer interest toward health and wellness. The company also extends its strong brand image into new product lines. Risks Competitors such as Coca-Cola and Cadbury-Schweppes will not stand still; they will also innovate and / or acquire other companies to capture rising consumer trends toward healthier products and overseas market. Coca-Cola is especially a challenging company, with comparable management strength and good margins in its products. Management turnover; if PepsiCos somehow lost its ability to raise and rotate managers. New product introductions are essential to continuing success; if they failed to generate consumer interest then sales and profits could be affected. Financial Performance

Over the past five years, PepsiCo has grown its revenue at a 6.5% compound annual growth rate. Over the same period, it has grown its net income even faster, at a 13.8% rate, as it has improved its net margin. Looking at its balance sheet, PepsiCo has a conservative debt-to-equity ratio (0.18), giving the company flexibility to increase leverage for acquisitions and share repurchases.
Exhibit 4 PepsiCos YTD Stock Performance (YTD as of November 23, 2007. Comparison with S&P 500 index and S&P Consumer Staples proxy)

Source: finance.google.com, retrieved November 23, 2007.

From the performance chart, PepsiCo (PEP) has performed well compared with S&P 500 and the companys proxy, S&P Consumer Staples (XLP). The stock has returned 20.71% as of November 23, 2007; compared with 1.58% of S&P 500 and 9.25% of XLP. Recently the board has authorized a stock repurchase program, worth $8.5 billion from 2006 to 2009. As of this write-up, PepsiCo has repurchased $1.1 billion of its stocks.
Exhibit 5 PepsiCos DCF Valuation Assumption is for stable sales growth.
Capital costs Current 10-year T-bond rate Equity risk premium PepsiCo stock beta PepsiCo current ke PepsiCo current kd Effective tax rate PepsiCo after-tax kd Terminal growth rate assumption Cost of capital Value per share Current Price Assigned 4.39% 4.9% 0.7 7.8% 6.50% 30.0% 4.6% 4% FCFF FCFE 7.64% 7.8% $103.75 $101.87 $75.04 11/21/2007

DCF valuation of PepsiCo has shown that there is room for the stock to appreciate. This is even considering a stable sales growth pattern that only goes up by 10% before tapering off. The sales growth is conservative if compared with previous several years; and the growth is pinned on the continuing double-digit growth and increasing portion of international sales. If the international sales hit a road-block, the DCF assumption will need to be adjusted and may present a different

valuation. However, at the time of this writing, the assumptions for above DCF value are considered to be reachable and very likely to occur.

Exhibit 6 PepsiCos Comparison with Peers Coca-Cola (KO), Cadbury-Schweppes (CSG), and Kraft (KFT)
Valuation Ratios P/E (TTM) Price to Sales (TTM) Beta Dividends Dividend Yield Dividend 5 Year Growth Rate Payout Ratio (TTM) Growth Rates Sales (TTM) vs. TTM 1 Year Ago EPS (TTM) vs. TTM 1 Year Ago Financial Strength Current Ratio (MRQ) LT Debt to Equity (MRQ) Interest Coverage (TTM) Management Effectiveness Return on Assets (TTM) Return on Investments (TTM) Return on Equity (TTM) Profitability Ratios Gross Margin (TTM) Operating Margin (TTM) Net Profit Margin (TTM) PEP $120b 20.23 3.24 0.3 KO $144b 26.64 5.24 0.71 CSG $25.9b 55.20 2.00 1.05 KFT $51.7b 20.58 2.71 0.66

1.99 15.07 35.53

2.18 11.49 56.44

1.65 4.94 127.51

3.23 29.86 62.31

8.22 28.33

15.82 4.64

6.3 -59.24

4.53 -15.91

1.23 0.18 26.94

0.78 0.08 55.06

0.58 0.46 3.24

0.94 0.39 8.35

19.11 25.31 38.07

14.92 22.61 28.91

2.15 3.08 6.27

4.53 5.53 9.18

54.69 18.54 16.48

64.21 25.27 19.83

11.31 8.43 3.52

34.95 11.78 7.26

Source: reuters.com, retrieved November 23, 2007.

With a P/E of around 20, PepsiCo is cheaper than some of its peers. Looking at the ratios comparison, PepsiCo is leading in term of management effectiveness (return ratios), and its beta means less volatility than some of its competitors. Payout ratio is important, in a sense that it would not burden the company too much to pay out dividends. With a ratio of 35.53%, PepsiCo still has rooms to adjust its dividends when either internal or external factors dictate it. Low LTdebt to equity ratio provides low distress cost for the company; however it also gives PepsiCo room to increase leverage if needed for expansion. Despite the low ratio, PepsiCo delivers strong Return on Equity (ROE) already. Comparing the profitability ratios, Coca-Cola is showing better numbers than PepsiCo. Overall, however, PepsiCo is still a more attractive company than the peers compared. Recommendation Following the qualitative evaluation of the company, PepsiCo is in a good position as a defensive stock for this economy. As a one of the largest food and beverage company in the world, PepsiCo provides a stable ground for the portfolio without the volatility associated with smaller companies. One analyst called it a true blue chip.7 PepsiCo has a better diversified portfolio compared to its immediate peer, Coca-Cola and and Cadbury Schweppes, allowing it to pursue stronger growth in segments such as alternative drinks and healthy snacks with the stability of its core segments (carbonated soft-drink and salty snacks). Its focus on international growth has shown in the financial performance, with doubledigits growth in many hot markets around the world for both snacks and sodas. The
- 13 PepsiCo Equity Research. Bear Sterns. 12 November 2007.

remarkable performance of the company is attributed to its deep-bench management team, which promotes individuals from within. Using the DCF valuation and comparison with peers, PepsiCo is evaluated to be attractive with potential of appreciation in stocks for the long term. Thus, the recommendation is to BUY 70 shares of PepsiCo for the PSU CFASPs portfolio. Reference Graves, Tom, Raymond Mathis, and Jeannine DeFoe. Industry Surveys: Foods & Nonalcoholic Beverages. Standard & Poors Industry Surveys. 7 June 2007. Annual Report 2006. PepsiCo. The Joy of Lizards: Pepsi Buys SoBe. beverage-digest.com. 30 October 2000. PepsiCo, Inc. Reuters ProVestor Plus Company Report. 23 November 2007. PepsiCo Inc. Ativo Research. 16 November 2007. Schwab Equity Ratings Report: PepsiCo, Inc. Charles Schwab & Co., Inc. 22 October 2007. PriceTarget: PepsiCo, Inc. PriceTarget Research. 6 October 2007. PepsiCo Inc. Argus Research. 16 November 2007. Hott, Justin, Christopher Tibollo, Charles Yan. PepsiCo Equity Research Bear Sterns. 12 November 2007. Laboy, Carlos, Anthony Bucalo. PepsiCo Equity Research. Credit Suisse. 13 November 2007. Mathis, Raymond. S&P Stock Report: PepsiCo Inc. Standard & Poor. 12 October 2007.

- 14 PepsiCo Equity Research. Bear Sterns. 12 November 2007.